A stock option is a contract that gives you the right to buy or sell a specific stock at a certain future price and date. There are two types of options: puts, which give you the right to sell a stock, and calls, which give you the right to buy a stock. You usually use them to "hedge your bets": puts when you bet that a stock will fall, and calls when you bet that a stock will rise.
How can I use options when I invest in stocks?
- You can use stock options as a means to hedge against volatility in the underlying stock. For example, due to market volatility, you have information that Apple's stock will rise from its current trading price of $116.60 in one year. However, you are not sure if the stock will rise for sure, so you purchase a call option. In a year, if the stock price rises to $130, you will exercise the option and buy the stock for only $116.60 and proceed to selling it on the market immediately for $130, earning a profit of $13.40 per share. However, if the stock price falls to $100, you will not exercise the option as you will incur a loss. Conversely, if you have information that Apple's stock will fall, you will purchase a put option instead. In a year, if the stock price drops to $100, you will exercise the option by short-selling the stock at $116.60 while immediately buying back the stock at $100 on the market, effectively earning a profit of $16.60 per share. If the stock price rises to $130, you won't want or need to exercise the option. This is also the reason why people turn to purchase options when the stock market volatility becomes too high as it helps to eliminate market risk by setting a strike price to buy or sell a stock in the future, regardless of the future stock price.
- However, buying and selling options is not free: you'll need to pay an option premium when you purchase the contract. If by the end of the contract, you decide not to exercise the option, you will end up losing the premium you paid for. Even if you do exercise the option, the profit you earn from it may not be enough to cover the premium you paid for the contract. Let's use the same example. You decide to purchase a call option, which is 100 shares of Apple's stocks at $116.60 and the stock price rises to $130 in 1 year. When the option expires, and you simultaneously buy the stocks for $116.60 each while selling them for $130 each on the market, you will have earned a return of $1,340. However, if the premium you paid for the option is $20 per share, which amounts to $2,000 for 100 Apple shares, then you effectively still make a total loss of $660.
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